Puerto Rico — U.S.’s ‘Greece’ — is hurtling to default

A severe liquidity crisis that threatens to shut down Puerto Rico’s government is making life difficult for U.S. municipal bond investors.

The island territory has been labeled “America’s Greece.” Its $73 billion in bonds trading in the U.S. municipal-bond market carry junk ratings and are trading at record-high yields.

In a letter last week, the island‘s Government Development Bank said the government would likely shut down in three months, unless lawmakers agree on a financing deal that would see the island double its sales tax in an effort to balance its budget and allow it to sell $2.9 billion in new bonds.

Last Friday, Standard & Poor’s downgraded the Puerto Rico’s credit rating to CCC-plus, pushing it even further into junk territory, while a Bank of America report dated April 17 warned of the danger of “widespread restructuring for the commonwealth.”

This isn't a new phenomenon. Puerto Rico has been stacking up debt to close its budget gaps and fund its operations for years, while growth has remained anemic. Its population is declining and its tax base is shrinking, said Antonio Fernós Sagebien, principal at REOF Capital, a Puerto Rico-based distressed-debt advisory firm.

Janney

Since Gov. Alejandro García Padilla’s took office in January 2013, lawmakers have passed a series of unpopular measures, including two rounds of pension cuts, $1 billion in new taxes, a hike in water rates and sharp reductions in the education budget. Now, lawmakers are reluctant to vote for yet another tax hike.

“The market is starting to realize that the liquidity problem was underestimated,” Fernós Sagebien said.

Puerto Rico bond prices have tanked in the past year, sending the yield on the benchmark general-obligation bond to 10.36% versus a level of 8.727% when it was issued in March 2014, according to data available on Electronic Municipal Market Access’s website. Bond yields rise as prices fall.

Considering that the bonds are also fully tax exempt nationwide, their yield is “unbelievably high,” especially for residents of high-tax states such as California, Jeffrey Gundlach, the founder of DoubleLine Capital, said in a March 10 conference call, according to Bloomberg. A DoubleLine spokesman declined to comment.

DoubleLine has increased its holdings of Puerto Rico debt to $45 million in its Income Solutions Fund, Bloomberg reported Monday. That is more than double the $20 million held in March, according to the report.

Meanwhile, nearly one out of every four municipal-bond funds that owned Puerto Rico debt sold it last year.

Puerto Rico’s debt consists of paper issued by different public entities—including the government itself, local agencies and public corporations. Each type of bond is backed by different public revenues, such as taxes, utility bills and tolls.

The price activity in the muni-bond market shows that investors are painting all Puerto Rico debt with the same brush, regardless of their individual fundamentals, according to a report from Janney Capital Markets.

Janney

What makes matters more complicated in a potential default is that nobody really knows what such a restructuring would look like, as “there is no precedent for it in the U.S.,” said John Ceffalio, vice president of municipal credit research at AllianceBernstein.

Puerto Rico cannot file for Chapter 9 bankruptcy, like Detroit did, and neither can its public corporations and local agencies.

A local law that created a legal framework for the restructuring of public corporations—including the island’s electric utility, which has over $8 billion in bonds outstanding and faces a potential July 1 default—was ruled unconstitutional by a federal court in February.

“As a result, there’s no road map for a potential restructuring, leaving investors guessing who would take precedence—those who hold debt of the central government or of separate agencies and corporations,” Ceffalio added.

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